As a day trader, there is potential to make significant long-term returns. Indeed, many people trade stocks for a living. However, as with any type of investment, day traders must be able to identify the risk/reward ratio of each investment, with risk management critical to long-term success. In this article, we will look at the principles of risk management that every day trader should understand and implement.
Understanding Risk and Reward
There is a strong relationship between risk and reward; in basic terms, if there is no risk, then there is no potential reward. Therefore, it is critical to appreciate the potential reward required to justify any high-risk investment. In the longer term, stock markets tend to find the fair value of stocks, but in the short term, volatility can present opportunities where a stock may be overbought or oversold. You will often see short-term difficulties impacting share prices, perhaps overshadowing long-term potential, until long-term investors replace the balance of short-term traders.
Setting Risk Tolerance
When considering risk tolerance, you need to consider the specific risk of each investment and the percentage of capital allocated to each trade. As a day trader, you must identify a level of risk with which you are comfortable. We are not suggesting you invest with the idea that all of your funds may be lost, but there may be volatility which could create a significant loss or gain. Whether looking at a day trader or a long-term investor, you must be comfortable with your level of risk. If you are out of your comfort zone, you will notice that this can play havoc with your emotions, often clouding your investment decisions.
Position Sizing
If you are looking to become a day trader, as well as risk, it is vital to address the issue of position sizing. Do you reduce the percentage of your funds invested in one trade, the higher the risk?
We all come across those potential investments which are "no-brainers", offering potentially huge returns, but very few of them turn out that way. It is important to constantly ask yourself why you are buying/shorting the stock, the potential upside and the potential downside, ensuring that one wrong trade doesn’t bring down your whole investment account. While knee-jerk reactions and momentum can impact short-term volatility but markets rarely get it wrong for too long. If the price of an asset is out of synch, it won’t be too long before the arbitrageurs appear.
Implementing Stop Loss Orders
One of the founding characteristics of day traders is the ability to implement stop-loss limits, which will maximise their gains while reducing their potential downside. If you cannot accommodate the use of stop loss limits, with your trading dominated by ego, this could be the first step towards disaster. We all get it wrong sometimes; the key is to limit your downside and walk away without significantly reducing your funding pot.
Diversification
Diversification can be a challenge for any day trader because they tend to focus on particular types of stock or sectors in which you have "expert knowledge". For example, if you were a day trader happy to take several positions in technology stocks, and the sector took a downturn, the cumulative hit on your positions could be significant. We are not suggesting you invest in areas in which you have no knowledge, but it is essential not to put all your eggs in one basket. There is a tendency to think that diversification is for those with a long-term investment horizon rather than a trader. This could be a very costly misconception!
Avoiding Overtrading
Overtrading is another problem that day traders and longer-term investors must try and avoid. Two primary drivers for overtrading are getting carried away with your short-term successes and believing every trade will bring a profit. On the flip side, if you experience a couple of losses, it can be tempting to jump straight back in, exposing you to overtrading and emotive trading. Be selective with your positions, resist the temptation to follow the trend with no knowledge and keep one eye on trading costs, which can impact your long-term profits.
Keeping Emotions in Check
This brings us to the most challenging of subjects when it comes to a day trader, or even a long-term investor, the ability to keep your emotions in check. This is more challenging for a short-term trader, who deals frequently and often for very short periods. It is crucial to find a balance between that gut feeling you develop as you become more experienced and dealing with pure emotion, buy now and regret later.
Fear and greed are two emotions which can be very lucrative for a day trader, but on the flip side, they could decimate your trading funds. Be careful!
Conclusion
As a day trader, there are many factors to consider, but the risk/reward ratio is critical. Looking at either of these elements in isolation does not give you the overall picture. It is also important not to overextend your portfolio to overly sized positions. Then we come onto perhaps the most important subject, keeping your emotions in check. Whether your trading is proving profitable or you are struggling, emotional knee-jerk reactions could prove to be your downfall. You should be in control of your investments and your decision-making process at all times.